International Economics: Theory and

Policy
Twelfth Edition

Chapter 2
World Trade: An Overview

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Learning Objectives
2.1 Describe how the value of trade between any two
countries depends on the size of these countries’
economies and explain the reasons for that relationship.
2.2 Discuss how distance and borders reduce trade.
2.3 Describe how the share of international production that
is traded has fluctuated over time and why there have been
two ages of globalization.
2.4 Explain how the mix of goods and services that are
traded internationally has changed over time.

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Preview
• Largest trading partners of the United States
• Gravity model: Influence of an economy’s size on trade;
Distance, barriers, borders, and other trade impediments
• Globalization: then and now
• Changing composition of trade
• Service outsourcing

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Who Trades with Whom?
• More than 30 percent of world output is sold across national
borders.
– World trade in goods and services exceeded $25 trillion in
2019.
• Figure 2-1 shows the total value of trade in goods—exports
plus imports—between the United States and its top 15 trading
partners in 2019.
– The largest 15 trading partners with the United States
accounted for 75 percent of the value of U.S. trade.
• The five largest trading partners with the United States in 2019
were Mexico, Canada, China, Japan, and Germany.

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Figure 2.1 Total U.S. Trade with Major
Partners, 2019

U.S. trade—measured as the sum of imports and exports—is mostly

with 15 major partners.
Source: U.S. Department of Commerce.
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Size Matters: The Gravity Model (1 of 3)
• Three of the top 15 U.S. trading partners are European
nations: Germany, the United Kingdom, and France.
• Why does the United States trade more with these
European countries than with others?
– These three countries have the largest gross
domestic product (GDP), the value of goods and
services produced in an economy, in Europe.
• Figure 2-2 shows that each European country’s share of
U.S. trade with Europe is roughly equal to its share of
European GDP.

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Figure 2.2 The Size of European Economies and
the Value of Their Trade with the United States

Shows the correspondence between the size of different European

economies and those countries’ trade with the United States.
Source: U.S. Department of Commerce, European Commission.
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Size Matters: The Gravity Model (2 of 3)
• The size of an economy is directly related to the volume
of imports and exports.
– Larger economies produce more goods and services,
so they have more to sell in the export market.
– Larger economies generate more income from
the goods and services sold, so they are able to buy
more imports.
• Trade between any two countries is larger, the larger is
either country.

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Size Matters: The Gravity Model (3 of 3)
• The gravity model assumes that size and distance are important for
trade in the following way:
A ´ Yi ´ Y j
Tij =
Dij

where A is a constant term

Tij is the value of trade between country i and country j

Yi the GDP of country i, Yj is the GDP of country j

Dij is the distance between the two countries

A ´ Yi a ´ Y jb
• Or more generally Tij =
Dijc

where a, b, and c are allowed to differ from 1.

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Using the Gravity Model: Looking for
Anomalies
• A gravity model fits the data on U.S. trade with European
countries well but not perfectly.
• The Netherlands, Belgium, and Ireland trade much more
with the United States than predicted by a gravity model.
– Ireland has strong cultural affinity due to common
language and history of migration. Ireland also hosts
many U.S.-based multinational corporations.
– The Netherlands and Belgium have transport cost
advantages due to their location.

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Impediments to Trade: Distance,
Barriers, and Borders (1 of 4)
Other things besides size matter for trade:
1. Distance between markets influences transportation costs and
therefore the cost of imports and exports.
2. Cultural affinity: close cultural ties, such as a common language,
usually lead to strong economic ties.
3. Geography: ocean harbors and a lack of mountain barriers make
transportation and trade easier.
4. Multinational corporations: corporations spread across different
nations import and export many goods between their divisions.
5. Borders: crossing borders involves formalities that take time, often
different currencies need to be exchanged, and perhaps monetary
costs like tariffs reduce trade.
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Impediments to Trade: Distance,
Barriers, and Borders (2 of 4)
• Estimates of the effect of distance from the gravity model
predict that a 1 percent increase in the distance between
countries is associated with a decrease in the volume of
trade of 0.7 percent to 1 percent.
• Besides distance, borders increase the cost and time
needed to trade.
• Trade agreements between countries are intended to
reduce the formalities and tariffs needed to cross borders
and, therefore, to increase trade.

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Impediments to Trade: Distance,
Barriers, and Borders (3 of 4)
• The United States signed a free trade agreement with Mexico
and Canada in 1994, the North American Free Trade
Agreement (NAFTA), which was replaced in 2020 with a
slightly modified agreement, the U.S.-Mexico-Canada
agreement (USMCA).
• Due to NAFTA and because Mexico and Canada are close to
3 .

the United States, the amount of trade between the United

States and its northern and southern neighbors as a fraction
of GDP is much larger than between the United States and
European countries.
– Canada’s economy is roughly the same size as Spain’s
(around 10 percent of EU GDP) but Canada trades as
much with the United States as does all of Europe.
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Figure 2.3 Economic Size and Trade with
the United States

The United States does markedly more trade with its neighbors than it
does with European economies of the same size.
Source: U.S. Department of Commerce, European Commission.
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Impediments to Trade: Distance,
Barriers, and Borders (4 of 4)
• Yet even with a free trade agreement between the
United States and Canada, which mostly use a common
language, the border between these countries still
reduces trade.
• Data shows that there is much more trade between
pairs of Canadian provinces than between Canadian
provinces and U.S. states, even when holding distance
constant.
• Estimates indicate that the U.S.-Canadian border deters
trade as much as if the countries were 1,500–2,500
miles apart.

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Figure 2.4 Canadian Provinces and U.S.
States that Trade with British Columbia

Source: Statistics Canada, U.S. Department of Commerce.

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Table 2.1 Trade with British Columbia,
as Percent of GDP, 2009

U.S. State at Similar

Canadian Trade as Trade as Percent Distance From British
Province Percent of GDP of GDP Columbia
Alberta 6.9 2.6 Washington
Saskatchewan 2.4 1.0 Montana
Manitoba 2.0 0.3 California
Ontario 1.9 0.2 Ohio
Quebec 1.4 0.1 New York
New Brunswick 2.3 0.2 Maine

Source: Statistics Canada, U.S. Department of Commerce.

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The Changing Pattern of World Trade:
Has the World Gotten Smaller? (1 of 3)
• The negative effect of distance on trade according to the
gravity models is significant, but it has grown smaller over
time due to modern transportation and communication.
• A global economy, with strong economic linkages
between even distant nations, is not new.
• There have been two great waves of globalization with
the first wave relying not on jets and the Internet but on
railroads, steamships, and the telegraph.

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The Changing Pattern of World Trade:
Has the World Gotten Smaller? (2 of 3)
• Political factors, such as wars, can change trade patterns
much more than innovations in transportation and
communication.
• World trade grew rapidly from 1870 to 1913.
– Then it suffered a sharp decline due to the two world
wars and the Great Depression.
– It started to recover around 1945 but did not recover
fully until around 1970.

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The Changing Pattern of World Trade:
Has the World Gotten Smaller? (3 of 3)
• Since 1970, world trade as a fraction of world GDP has
achieved unprecedented heights.
• Vertical disintegration of production has contributed to the
rise in the value of world trade through extensive cross-
shipping of components.
– A $100 product can give rise to $200 or $300 worth of
international trade flows.

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Figure 2.5 The Fall and Rise of World
Trade

The ratio of world exports to world GDP rose in the decades before World War I
but fell sharply in the face of wars and protectionism. It didn’t return to 1913 levels
until the 1970s but has since reached new heights.
Source: Michel Fouquin and Jules Hugot, “Trade Globalisation in the Last Two Centuries,”
Voxeu (September 2016).

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What Do We Trade? (1 of 3)
• What kinds of products do nations trade now, and how
does this composition compare to the past?
• Most (about 70 percent) of the volume of trade today is in
manufactured products such as automobiles,
computers, and clothing.
– Fuels and mining products (e.g., petroleum, coal,
and copper) remain an important part of world trade
at 15 percent.
– Agricultural products are a relatively small part of
trade at 10 percent.

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Figure 2.6 The Composition of World
Trade, 2017

Most world trade is in manufactured goods, but minerals—mainly oil—

remain important.
Source: World Trade Organization.
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What Do We Trade? (2 of 3)
• In the past, a large fraction of the volume of trade came
from agricultural and mineral products.
– In 1910, Britain mainly imported agricultural and
mineral products, although manufactured products
still represented most of the volume of exports.
– In 1910, the United States mainly imported and
exported agricultural products and mineral products.
– In 2002, manufactured products made up most of the
volume of imports and exports for both countries.

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Table 2.2 Manufactured Goods as
Percent of Merchandise Trade
Blank

Exports of United Imports of United Exports of United Imports of

Kingdom Kingdom States United States
1910 75.4 24.5 47.5 40.7

2015 72.3 73.6 74.8 78.4

Source: 1910 data from Simon Kuznets, Modern Economic Growth: Rate, Structure
and Speed. New Haven: Yale Univ. Press, 1966. 2015 data from World Trade
Organization.

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What Do We Trade? (3 of 3)
• Low- and middle-income countries have also changed the
composition of their trade.
– In 2001, about 65 percent of exports from low- and
middle-income countries were manufactured products,
and only 10 percent of exports were agricultural products.
– In 1960, about 58 percent of exports from low- and
middle-income countries were agricultural products and
only 12 percent of exports were manufactured products.
• More than 90 percent of the exports of China, the largest
developing country and a rapidly growing force in world trade,
consist of manufactured goods.

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Figure 2.7 The Changing Composition of
Developing-Country Exports

Over the past 50 years, the exports of developing countries have

shifted toward manufactures.
Source: United Nations Council on Trade and Development.
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Service Offshoring (1 of 2)
• Service offshoring (or outsourcing) occurs when a
firm that provides services moves its operations to a
foreign location.
– Service outsourcing can occur for services that can
be transmitted electronically.
▪ A firm may move its customer service centers
whose telephone calls can be transmitted
electronically to a foreign location.
• Other services may not lend themselves to being
performed remotely.

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Service Offshoring (2 of 2)
• Service outsourcing is currently not a significant part of
trade.
– Some jobs are “tradable” and thus have the potential
to be outsourced.
– Most jobs (about 60 percent) need to be done close
to the customer, making them nontradable.

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Figure 2.8 Tradable Industries’ Share of
Employment

Estimates based on trade within the United States suggest that trade in
services may eventually become bigger than trade in manufactures.
Source: J. Bradford Jensen and Lori G. Kletzer, “Tradable Services: Understanding
the Scope and Impact of Services Outsourcing,” Peterson Institute of Economics
Working Paper 5–09, May 2005.

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Do Old Rules Still Apply?
• The sources of modern trade are more subtle than before.
– Human resources and human-created resources (in the
form of machinery and other types of capital) are more
important than natural resources.
– Political battles over trade typically involve workers whose
skills are made less valuable by imports, such as clothing
workers who face competition from imported apparel, and
tech workers who now face competition from Bangalore.
• Even though much about international trade has changed, the
fundamental principles discovered by economists at the dawn
of a global economy still apply, as we shall see in the
upcoming chapters about why international trade occurs.

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Summary (1 of 2)
1. The five largest trading partners with the United States
are Mexico, Canada, China, Japan, and Germany.
2. The largest economies in the EU undertake the largest
fraction of the total trade between the EU and the United
States.
3. The gravity model relates the trade between any two
countries to the sizes of their economies. Using the
gravity model also reveals the strong effects of distance
and international borders in discouraging trade.

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Summary (2 of 2)
4. International trade is at record levels relative to the size of
the world economy, thanks to falling costs of transportation
and communications. The world was highly integrated in
1914, but trade was greatly reduced by economic
depression, protectionism, and war and took decades to
recover.
5. Manufactured goods dominate modern trade today. In the
past, however, primary products were much more important
than they are now.
6. Developing countries, in particular, have shifted from being
mainly exporters of primary products to being mainly
exporters of manufactured goods.

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